How big should you bet, how much should you trade? Usually, traders approach this question by risking a fixed percentage of their account size per trade – the classic answer being “never risk more than 1% (or maybe 2%) per trade”.
The problem with this approach is that it assumes that the stop loss will be executed. For example, I think the EUR/USD looks bullish at 1.1230 and the right place for a stop loss is 1.1180. I am prepared to lose 1% of my account’s value if I lose the trade, so I calculate the 1%, divide it by 50 pips, and that is my trade size per pip. What if my stop loss is not executed at 1.1180? What is the price moves in a flash down to 1.1000, say, before it is executed? I would lose about 5% of my account, instead of the 1% I had initially budgeted for. A real-life example of such a problem occurred in the Forex market in 2015, when the Swiss Franc moved by about 30% before anyone could exit an open trade. A typical day trader on the wrong side of that would have ended up not being wiped out, but owing their broker extra money!
There are a few possible answers to this problem. One could be to use guaranteed stop losses, which some brokers offer. The disadvantage of that is that guaranteed stop losses are expensive, typically widening the effective spread by 300%, so for day traders it is not a viable option.
Another alternative is to look at the largest ever daily movements in currency pairs, or any other instruments such as stocks or commodities which you might trade, and assume that one day you could be forced into taking a similar-sized loss. For example, the Dow Jones Index moved by 22.6% in one day, back in 1987, so if the biggest loss you are prepared to take is about the same amount, you probably should never be leveraged when trading a major stock index. That was the biggest ever daily movement in the stock exchange’s entire history. Gold futures could be another example – the biggest one-day movement since 1975 (only a few years after the USD began to float freely against Gold) was 12.18%, so if you are prepared to suffer a maximum loss of about 25%, you could allow a total position size approximately twice the size of your account. These could be absolute maximum position sizes, which would be further adjusted in accordance with recent volatility. It would certainly be a more intelligent way to manage risk than assuming your broker will execute your stop loss in a major market crisis!